FINRA Arbitration filed against Morgan Stanley to recover Reverse Convertible Note Losses

March 23, 2012 - PRLog -- The claim, filed against Morgan Stanley Smith Barney, seeks recovery of investment losses incurred as a result of the investor’s investment in 3 reverse convertible notes.

The claim filed by The White Law Group was submitted on behalf of a 92 year old Florida investor and alleges claims for fraud, breach of fiduciary duty, negligence, and negligent supervision. The claim specifically alleges that the investor was unsuitably invested in three reverse convertible notes and that Morgan Stanley failed to properly disclose the risks and complexity of the reverser convertible notes.

Reverse convertibles are extremely complex investment instruments that are not suitable for most investors.  

According to FINRA, “[t]hey are complex investments that often involve terms, features and risks that can be difficult for individual investors and investment professionals alike to evaluate.”  See the FINRA Investor Alert, Reverse Convertibles - Complex Investment Vehicles; see also FINRA Regulatory Notice 10-09, FINRA Reminds Firms of Their Sales Practice Obligations With Reverse Exchangeable Securities (Reverse Convertibles).

A reverse convertible note (“RCN”) appears at first glance as similar to a note or bond that pays a relatively high interest rate or coupon (7% up to 25%) over a short period of time (usually 6 months to a year).  At maturity, the investor will receive the interest payments plus either 100 percent of his original investment or a predetermined number of shares of an underlying stock.  Therein lies the allure to unsophisticated investors - they will receive a decent return on their investment in addition to the return of their capital within a short period of time (in theory).

However, an RCN is accompanied by high risk which is not readily apparent to the unsophisticated investor.  In fact, the investor bears all of the downside risk while the issuer of the note receives all of the potential upside.  

Tied to the RCN is an underlying stock, whose value during the life of the note will determine what return the investor will receive.  When the RCN is sold to the investor, a set price is determined for the underlying stock that is tied to the note; if at any time during the life of the note the value of the underlying stock ever drops below this predetermined point, the investor’s note will convert to a predetermined number of shares of that underlying stock.  Thus, an RCN may be thought of as a debt instrument tied to a put option.

As such, in addition to taking on the credit risk of the issuer, investors accept price risk related to an underlying security.  Meanwhile the issuers who carefully structured these complex investments pass on their risk to unsuspecting investors.  Notably, the issuers of RCNs are generally large financial institutions such as Morgan Stanley or UBS, while investors are typically unsophisticated individuals who are attracted by the high coupon rate without understanding the full scope of the risk they are undertaking with these highly complex investment instruments.

Furthermore, RCN issuers charge an up-front fee for assembling and packaging the individual components of a reverse convertible.  Typically ranging from 1 percent to 8 percent or more, these fees are usually described in prospectuses as “built-in costs” or “costs of hedging,” and the exact amount of the fee is often not disclosed to the investor.  

Altogether, RCNs represent extremely complex, high-risk and frequently illiquid investments that are difficult for unsophisticated investors to comprehend and are unsuitable for most investors.

For more information on the claim filed by The White Law Group, please contact the firm’s Chicago office at 312-238-9650.

# # #

The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm.

For more information on The White Law Group, visit http://www.whitesecuritieslaw.com.